Bonds and Social Security

Why you should (almost) never own government bonds.

It’s no secret that I don’t really like bonds, and I’ve mentioned this dislike before, I’ve even written 2 posts on this blog outlining the good things and bad things about bonds.

That said, I still acknowledge that bonds do have a place in a portfolio, if only due to a diversification lens.

But is a 60/40 portfolio really the end-all-be-all?

Let’s talk about that.

The Problem

I want to be clear here:

If you have any government bonds, you’re overweight on government bonds.

That’s not a joke, that’s not an exaggeration, that’s not an extremist position.

Any amount of government bonds in your investment portfolio is an overweight position on government bonds.

You can make a very good argument that not shorting government bonds is introducing a pro-government bond bias into your portfolio.

Naturally there are costs (direct and indirect) to shorting things that might make shorting government bonds unattractive, which is why I don’t do it, but from a pure theoretical portfolio allocation perspective shorting government bonds is most likely the best option for most people.

The reason for this is simple and quite easy to understand, as a general rule your asset allocation should seek to mirror the overall market allocation, in order to track the market average as closely as possible.

We’ve talked about why that is in previous posts, most recently here, and so if you already have a significant amount of government bonds, it makes little sense to purchase more.

And the fact of the matter is that for 99% of people, they already have meaningful amounts of government bonds, and they legally cannot divest them (or stop investing in them).

Why? Because Social security is a government bond.

I’ve read a very nice article on how to value this asset and i reccomend you check it out as well, but the gist of it is the following:

1. Social security is a forced purchase of an asset

2. That asset is supposed to provide income over time (once you retire)

3. That income will come from the state coffers and revenues

4. Some part of the revenue will come from investment assets, which are mostly government bonds

Given all this, and considering the significant part of peoples retirement income which is expected to come from Social security its clear that in many countries well over 60% of peoples incomes are coming from social security (ie: the government bond).

If we add another 16% to that from the 60/40 portfolio that comprises the remaining 40% of the income replacement, we can see that well over 3 quarters of peoples income in retirement is directly coming from government bonds.

This is an asset allocation that is highly concentrated (and as such risky)!

Summary

In short, most people already have the bulk of their retirement income coming from government bonds.

Even disregarding political risks, the concentration risk alone is enormous and should be diversified away.

Most people would be better served by fully divesting themselves of government bonds wherever they can, because social security is not something that can be divested.